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Dunkin’ Brands Group, Inc. (NASDAQ:DNKN)

Q2 2014 Earnings Conference Call

July 24, 2014 08:00 ET

Executives

Stacey Caravella - Director, Investor Relations

Nigel Travis - Chairman and Chief Executive Officer

Paul Carbone - Chief Financial Officer

John Costello - President, Global Marketing and Innovation

Analysts

John Ivankoe - JPMorgan

John Glass - Morgan Stanley

Jeffrey Bernstein - Barclays

Joseph Buckley - Bank of America Merrill Lynch

David Palmer - RBC Capital Markets

Will Slabaugh - Stephens

Jeff Farmer - Wells Fargo

Andy Barish - Jefferies

David Tarantino - Robert W. Baird

Matt DiFrisco - Buckingham Research

Michael Gallo - CL King

Operator

Good day, ladies and gentlemen and welcome to the Dunkin Brands Second Quarter 2014 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions)

I will now introduce your host for today’s conference, Stacey Caravella, Director, Investor Relations. You may go ahead.

Stacey Caravella

Thank you, operator, and good morning, everyone. With me today are Dunkin Brands’ Chairman and Chief Executive Officer, Nigel Travis and Dunkin Brands’ Chief Financial Officer, Paul Carbone. Each of whom will speak on today’s call. Additionally, Dunkin Brands President, Global Marketing and Innovation, John Costello is here and will be available for questions during the Q&A session at the end of the call. Today’s call is being webcast live and recorded for replay.

Before I turn the call over to Nigel, I would like to remind everyone that the language on forward-looking statements included in our earnings release also applies to our comments made during the call. Our release can be found in our website, investor.dunkinbrands.com, along with any reconciliation of non-GAAP financial measures mentioned on the call with their corresponding GAAP measures.

Now, I would like to turn the call over to Nigel.

Nigel Travis

Stacey, thank you very much and good morning everyone. Thank you for joining today’s call to discuss our second quarter 2014 results. Our performance in the second quarter was disappointing as we faced challenges both domestically and internationally. While we are proactively addressing these challenges and feel confident in our ability to return to our longer term growth targets, today we are updating some of the guidance that we provide for 2014 to reflect our performance year-to-date and expectations for the back half of the year.

Let me first address comparable store sales for Dunkin Donuts USA. Coming now to the first quarter, we were hopeful that as the weather improved, sales growth would bounce back and that we would be able to get back the 3% to 4% range for the full year. Unfortunately, sales momentum didn’t accelerate as fast or to the degree that we anticipated. Now, we believe there are several reasons for this including number one, a variety of macroeconomic challenges facing consumers, which is evident across the retail and the quick-service restaurant industries; secondly, continued intense competitive market activity; and thirdly, an un-seasonally cold and rainy start for the spring season.

So, let me start with the weather first. Coming off such a well-documented tough winter season, we struggled to gain momentum earlier in the quarter. But to be clear, the negative weather effect in the quarter was less than 100 basis points on the quarter. There were many headwinds that continued to challenge consumers from job growth failing to improve, a reduction in government programs, lackluster GDP growth to even the residual expense from increased heating costs. There appears to be a mix of many macroeconomic factors negatively impacting a significant segment of the consumer population and we believe this has affected not only our business, but many other QSR and retail concepts.

Despite the disappointing numbers versus our expectations, week-after-week we beat the industry when we looked at these numbers. Our performance from the first week in April through the week ending July 6 was stronger than the performance of the remainder of the sales track weekly QSR participants, as measured by the MPD Group. Our conclusion is that it was a very tough quarter for both the QSR industry and the retail sector, which the numbers being reported by other companies are supporting that the consumer particularly at the lower end is in a tough spot. Lower income households were impacted hardest by the recession and the lowest income population continues to struggle which is making the value space highly competitive.

So that brings me to the competitive environment. There is no doubt that breakfast is the most competitive out-of-home eating day part. And everyone wants to be in the beverage business. While new entrants into the space doesn’t necessarily have a direct impact on us, they increased the overall competitive intensity from existing players. As a result, deep discounting is pervasive in the beverage space from QSR players, the guests in convenience stores. Therefore given the macroeconomic environment and the competitive intensity, we now expect full year comp growth of 2% to 3% versus the 3% to 4% that we initially guided earlier this year.

I will go into more detail shortly about Dunkin USA comps in the second quarter. On the international business we are facing a few issues. We are struggling to get comp momentum on both brands internationally given the weak performance in two of our largest markets as Baskin Robbins in Japan and Dunkin Donuts in Korea. The performance of each significantly impacts the respective segments comp results and both markets are facing long-term turnarounds.

For the second half of the year, we expect continued weak performance by the joint ventures along with lower than anticipated profit from the sale of ice cream in Baskin Robbins International. With the impact of our net income from the lowered comp store sales and international expectations where we are advising our adjusted earnings per share target for the full year from the previous range of $1.79 to $1.83 a share and we are now expecting the EPS of $1.73 to $1.77, which when you look at that new range still represents 13% to 16% year-over-year growth. While we are revising our near-term targets, we are maintaining our long-term growth targets and remain very confident in the global growth opportunity.

In fact we had another quarter of very strong domestic Dunkin Donuts development adding 75 net new restaurants. In June we announced the locations of the first five Dunkins that will open in California in just a few months. We have opened 12 net new Baskin Robbins locations in the USA and for international we opened the 50th Dunkin Donuts in Germany and our first Dunkin Donuts restaurant in Luxembourg and on July 1, the very first Baskin Robbins opened in the Philippines.

Now let me go into further detail on Dunkin Donuts U.S. comp store sales growth in the second quarter. The business delivered 1.8% comps. During the quarter we continued to introduce new limited time offer products that differentiate us from the competition and drive consumer excitement. Examples are the Chicken Apple Sausage Breakfast Sandwich and we also used smart discounting to drive traffic and trial of key products such as iced coffee, iced and hot espresso, iced tea and Coolattas.

Transactions marked more than half of the comp store sales growth in the quarter. We are very encouraged by this transaction growth especially coming off the first quarter during which the severe weather caused a slight transaction decrease. Of the ticket growth, up to 50 basis points came from pricing. Overall price increases were partially offset by strategic discounting such as the PM break promotion that we offer in a number of markets. But we feel good about this discounting because it’s driving traffic and beverage trial and both are very important.

More positive news is that we feel growth in both the morning and afternoon day part. In fact during the quarter we had the highest afternoon guest count on record. This was partially driven by franchisees implementing the coffee break offers to bring guests back in the afternoon. Encouragingly we didn’t see – we did see improvements throughout the quarter with average weekly sales in June reaching the highest volume on record. So while we are disappointed in the overall comp growth in the quarter, we did see some encouraging signs. And as I said earlier we outperformed the industry. And importantly we remained highly confident in our ability to drive long-term growth for Dunkin Donuts in the USA. We are driving beverage trial and day part expansion today that provides platforms for future growth. Additionally, our product pipeline is incredibly impressive. In fact, the rate and pace of testing during the second quarter was stronger than it has been in my time here at the company. And as we have shown, new innovative products drive the business and technology is another way we are planning to drive and transform our business.

We have reached nearly 8 million downloads of the Dunkin Donuts mobile app and we are over 1.3 million Dunkin Donuts Perks Rewards members. Also, we now have more than 2,000 Dunkin Donuts U.S. stores showing comp growth through investing in digital menu boards. As we said on the first quarter call, we want to give the Perks program a full year before we discuss the program in greater depth, so that we can quantify the impact from the business and what it can ultimately mean for us long-term. All signs from the program were positive during the quarter and we remain convinced that Perks will be a significant driver of growth in the future. And we are ahead of plan to reach our aggressive goal of 2.5 million members by the end of the quarter.

Now, let’s turn to Baskin Robbins U.S. and it really was an outstanding quarter all round for Baskin Robbins in the USA with great comps and net development. The segment had its fifth straight quarter of positive comps and that is the second quarter with a 4.2% comp growth. Our (indiscernible) program through which customers receive a free waffle cone when they purchase the second scoop is now a brand standard, is helping drive sales even when the weather is challenging and importantly it’s great for franchisee margin dollars.

Cake sales were another highlight in the quarter. Mother’s Day and Father’s Day cakes were great success. Our online cake ordering continues to gain strength. We are in the process right now of transitioning from a 48-hour minimum advanced order time to 24 hours, which is proven already to drive online sales, where it’s in operation. So, as we continue to learn and improve upon online cake ordering already is proving to be an important growth driver for Baskin in the U.S. Finally, on Baskin Robbins, we are really pleased with the 12 net new restaurants in the second quarter, but I would like to point out to everyone that this isn’t the quarterly run rate we expect for the balance of the year.

Now, let’s switch to international. As I have said earlier, comp store sales growth for Baskin Robbins International is largely driven by the performance of our joint venture restaurants in Japan, which represents approximately 40% of the segment sales. And certainly on the Dunkin side, comp store sales growth is heavily affected by the performance of our joint venture restaurants in Korea, where they represent 45% of the segment sales. As a point of reference, comps for both international segments would have been positive, excluding Japan and Korea.

We continue to work hard with our joint venture partners in both countries to accelerate sales growth, but it’s going to be a longer term turnaround process. Notably for Baskin Robbins International, Korea and Middle East each had strong second quarter comp performances with product and marketing innovation leading the way. In Korea, this included capitalizing on the Children’s Day holiday and in the Middle East, it was focus on the Chocolate Mousse Royale last Sunday, which was also the feature product in the UK. Taking the second product is a great example of using our global strength to leverage products across multiple markets.

For Dunkin International, the Middle East had a strong second quarter largely driven by product innovations and consistent investment in media, two strategies that we are emphasizing everywhere with our international franchisees. And our strong new market openings included in the Munich and Mumbai during the second quarter continued to illustrate the global consumer demand for Dunkin Donuts.

Lastly, we celebrated Global Donut Day in June in 31 countries around the world generating more media impressions and social media interactions than ever before. Despite the disappointing comps, I am encouraged by what is happening across the international and here are some highlights. We are now employing the same operational and development rigor that we have seen in the USA. And globally, standards are quickly improving. New store openings in Europe have been strong, especially in Germany and Dunkin Donuts India is posting very strong comps on opening in new cities.

We are beginning to make progress to converting the initial donut sales explosion that we see in new stores internationally to higher margin beverage and sandwich sales that’s a very important initiative. Cake innovation in Baskin Robbins is extensive as I mentioned before and also incredibly impressive as our tests of online ordering and delivery in some markets. Our global ice cream cake day on October 1 will be an important galvanizing event. Similar to the U.S. our use of digital marketing is expanding at a rapid pace. And we are confident in our plans for turning around both brands in China.

In closing, before I hand it over to Paul, despite a tough first half to 2014, I remain very enthusiastic about our business. We are focused on addressing the near-term challenges. And we and our franchisees are investing for the future to ensure a strong foundation for long-term growth. So what does that mean, and I am going to give you a number of points here. Number one, growing units per transaction in Dunkin Donuts U.S. to capitalize on the traffic that we are driving into our business and we have several new platforms that will aid this initiative. Number two, continuing to drive beverage trial to build rituals and introduce guests to more premium price beverages through sampling and great day part offers. Number three, ramping up Dunkin Donuts Perks so that we can fully harness the power of one-to-one marketing to grow the sales. Four, continuously finding ways to take our guest satisfaction tools to even higher levels.

Number five, building on the success of new franchisees who have taken over tough markets and are driving renewed growth. There is a pipeline of franchisees looking for such opportunities. Number six, retaining our strong focus on franchisee unit economics. Importantly we continued to see franchisee restaurant level EBITDA increase. As such demand for new and existing franchisees is very high. In fact sometimes telling people they haven’t got a market is our biggest challenge. Number seven, finally from a G&A standpoint it’s ensuring that we are constantly looking how we are allocating our resources across the business to support near and long-term growth. In particular we have shifted more resources to international during the quarter. And these are some of the ways that we are addressing our challenges and future opportunities.

And with that I will turn it over to Paul.

Paul Carbone

Thanks Nigel and good morning everyone. During the second quarter our franchisees and licensees opened 151 net new restaurants globally. In the U.S. Dunkin Donuts franchisees opened 75 net new units versus 63 last year. By region 31% of the second quarter net development was in our core markets, 31% in our established markets, 22% in emerging and 16% in the West. During the quarter our franchisees completed 94 remodels. Baskin Robbins U.S. franchisees added 12 net new units during the first quarter versus 5 net new units last year. Baskin Robbins International added 47 net new restaurants versus 50 last year. Growth was primarily in the Middle East. And Dunkin Donuts International added 17 net new restaurants versus 33 last year with growth primarily in both Europe and the Middle East.

So now let’s turn to our second quarter financial results. Revenue for second quarter was $190.9 million, which was a 4.6% increase compared to the prior period – prior year period driven primarily from increased royalty income due to system wide sales growth. Operating income for the second quarter was $87.6 million for an increase of $10.8 million or 14% over the prior year period. The increase was primarily as a result of the revenue growth and the gain recognized in connection with the sale of our company owned restaurants in the Atlanta market. Additionally, the prior year period included a one-time $7.5 million charge related to a third party product volume guarantee and a $7 million gain related to the sale of 80% of our Baskin Robbins Australia business. Adjusted operating income was $94.2 million for an increase of $3 million or 3.3% as a result of the growth in revenue and the gain on the sale of the Atlantic company owned stores, offset by the gain from the sale of the Baskin Robbins Australia business last year.

Net income for the second quarter was $46.2 million for an increase of $5.4 million or 13.2% primarily as a result of an increase in operating income and a $3.1 million decrease in interest expense offset by more than $9 million increase in income tax expense.

Adjusted net income was $50.2 million, which represented an increase of $6.3 million or 14.3% as a result of the increase in adjusted operating income and the decrease in interest expense. Diluted adjusted earnings per share increased by 14.6% to $0.47 as a result of the increase in adjusted net income and the decrease in shares outstanding. The decrease in shares outstanding from the prior year period is due primarily to the repurchase of shares offset by the exercise of stock options. During the second quarter, we repurchased a total of 1,260,000 shares. Our diluted weighted average shares for the quarter were 107.2.

And at the end of the second quarter, we had a debt to adjusted EBITDA ratio of 4.5:1. And during the quarter, our effective tax rate was 35%. During the quarter, we had $59 million in free cash flow. We ended the quarter with a $176 million in cash on the balance sheet. Of that $176 million, $99 million represents cash associated with our gift card programs and marketing fund balances. We used $24 million in cash during the quarter to pay our second quarter dividend to shareholders and $59 million to repurchase shares during the quarter.

As Nigel mentioned earlier, we are updating some of our full year target today to reflect both our year-to-date performance as well as our second half expectations. So, let me walk you through our guidance in more detail. Nigel covered our revision to Dunkin Donuts U.S. comp sales growth, which now is expected to be between 2% and 3%. We are maintaining our Baskin Robbins U.S. comp store sales growth guidance of 1% to 3%. We are also maintaining all of our restaurant development targets and let me just cover those again.

Dunkin Donuts U.S. led between 380 and 410 net new restaurants and Baskin Robbins U.S. will add between 5 and 10 net new restaurants. Internationally, we expect to open between 300 and 400 net new restaurants across the two brands. We are updating our revenue growth target for the year to 5% to 7% growth from our previous target of 6% to 8%. This is primarily driven by the change in Dunkin Donuts U.S. comp store sales.

We now expect adjusted operating income to grow between 7% and 9%. Previously, we expected 10% to 12%. This is primarily driven by ice cream volume and margin compression and reduced joint venture net income. We guided earlier this year to $17 million in joint venture net income. We now expected to be $15 million. With the changes in our revenue and adjusted operating income target, we are also updating our adjusted operating income margin expansion target from previous of a 150 to 200 basis points to a new guidance range of 50 to 100 basis points.

We are also updating our adjusted earnings per share target to a $1.73 to a $1.77 from the previous target of $1.79 to a $1.83. Our new target is based on diluted weighted average shares for the full year of a $107.4 million which is inclusive of the year-to-date share repurchases. From a magnitude impact, here is how each item I mentioned previously effect our full year’s earnings per share target. There is four items; first, the revision to Dunkin Donuts U.S. comps is nearly $0.03 of negative impact to EPS, ice cream volume in margin compression in the BR International segment is approximately $0.03 of negative impact and the reduction of JV net income is approximately $0.01 of negative impact. Offsetting these is approximately $0.01 of positive impact from the shares repurchased in the second quarter. Lastly on free cash flow, we continue to expect approximately 15% growth over our 2013 free cash flow.

And now, I will turn it over to the operator to open the line for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from John Ivankoe of JPMorgan. Your line is open.

John Ivankoe - JPMorgan

Great, thank you so much. I am not used to hearing Dunkin in the U.S. being very sensitive to quarter-to-quarter changes in competition. So, I was hoping that we could elaborate a little bit on that? Maybe specifically what did change relative to previous years? And I think importantly as it relates to your brand, did you see different levels of performance in the core market that you may have a more frequent brand loyal customer versus non-core markets, where brand loyalty maybe hasn’t been as established? And I have a follow up as well.

Nigel Travis

Okay. So, John, good morning, I think the key element was that we saw our customers have strong loyalty. I mean, that was I think if you like demonstrated by what was – what we think is significant growth on our Perks program. I think there was clearly as I explained in my comments an integration of more competition, which actually made people discount more. So, I think the changes were discounting. I think our franchisees responded extremely well. I think in the last I would say a year and a half, we have become much more fast, changing the different circumstances that are happened with competition. And we have educated our franchisees, I think that is important to hang on to the share gains that we have and I would like to reaffirm that during the quarter we actually gained shares, in fact probably significant share. We can’t actually give you the actual numbers, so we don’t know them. But based on what we say, we see share gains. However, the amount of competitive intensity was such that I think the discounting effectively impacted outcomes, because it affected the actual yield per transaction. So, in conclusion, we drove transactions, that was supported by discounting to go against the more intense competition and in turn our loyalty and share grew.

Back on your question about regional comps, I think there is some demonstrable evidence that in the Northeast that there has been some pressure on consumers. However, we did pretty well in our core and established markets. And those are the areas of comps there were actually higher than some of our other markets, where I think the impact was the percent of new stores that are going against the initial donut rush, whereby we open a store, it has huge numbers and by the way this is going to be an issue we have faced in international. Good example is the stores that you personally are very well known as having visited a lot in Frankfurt where you open with a very large number supported by donuts, that impacts the comps in the second year. So, overall, the comps were basically flat, apart from that donut, they say, explosion that we have to complicate. John, do you have a follow-up?

John Ivankoe - JPMorgan

Yes, thank you so much. And maybe as it relates to kind of that core and established market performance that you have. As you have kind of rolled out DD Perks, have you found that it actually has driven incremental transactions and incremental transactions to offset that net discounting or is that still something that still needs to build, but at least somewhat of the fear is the program initially may just basically provide a discount to your most frequent, most loyal customers that would have come in anyway?

John Costello

Yes, John, John Costello. So yes, you kind of summarized we are building transactions throughout the U.S. We are building market share, the discounting put pressure on ticket. What we are seeing in Perks is it’s ramping up very quickly. We are very pleased with the results of perk and the customer adoption. It’s too early to decompose Perks to get the specific impact as it relates to discounting. So, while we are very encouraged by Perks, we are very encouraged by the ramp up. We don’t have enough base data to answer your specific question, but to Nigel’s point, what encourages is third-party tracking shows we are building share and we are growing transactions and guest count in the stores, which is a sign of vitality. But in the phase of many people giving away free coffee, which we just had to sharpen the offers that we offered throughout the country and that sharpening of the offers and the discounting shaves average ticket price, which affected comps.

Nigel Travis

Thanks, John. Next question?

Operator

Thank you. Our next question comes from John Glass of Morgan Stanley. Your line is open.

John Glass - Morgan Stanley

On your comp guidance for the year of two to three year, still need to get I think a 3% comp roughly in the back half to get to 2. So, or two plus so, what evidence do you have that that’s actually occurring or what are you changing from a marketing standpoint so you don’t wind up in this situation next quarter where it was a little lower. So if you could talk about that. Paul also just what was the gain of Atlanta, just from a modeling standpoint?

John Costello

Yes, John, it’s John Costello. I think part of it is just the math, we feel we’re encouraged about the second half, but – so what you will see in the second half is several things. From a marketing standpoint, you will see continued product innovation for example, right now, if you’ve been in our stores, we’ve rolled out the Steak Breakfast Burrito, which is off to a good start. We’ve got a steady range of both food and beverage LTO’s out there. You can also see in our stores from the – we also launched a new grilled chicken product in June so, which you will see in terms of platforms rolling over last year is continued growth – in addition to all of our breakfast sandwich LTO’s and the continued growth of our PM sandwiches, you will see the increased impact of our breaded chicken new platform, our grilled chicken net platform, our Angus Steak new platform.

In addition to that, you will see the continued ramp-up of DD Perks. As Nigel mentioned we recently surpassed 1.3 million members on DD Perks. We’re just under 8 million members on mobile. So those continue to grow in size, which increases their marketing impact so you put that altogether what you will see is very strong product innovation, continued growth of mobile, continued growth of DD Perks, and also we’ll start to – if you will rollover some of the strategic discounting that we began to implement last year, which offers – much of that discounting is in our PM breaks and while those PM breaks may shave some dollars off of ticket, they are bringing people back in the afternoon, where our stores are a lot less crowded, so that’s a net incremental business to franchisee profitability. So, it’s four or five different factors all ramping up in the second half, you didn’t do the math of what we achieved in the first half and that gets to the full year guidance.

Nigel Travis

Yes, thanks John. So John on the – let me just quickly touch on the comps, just to add onto what John Costello said and then I will talk about Atlanta. So, year-to-date we are at plus 1.5, so that you would say to get to the low end, we have to do 2.5 for the balance of the year to get to the low end of the guidance. Couple of thoughts there in addition to all of the programs, John was talking about, if you look at the second quarter, business got sequentially better throughout the quarter from a one-year comp basis and a two-year comp basis so we left the quarter on a high note. So we feel good about the back half of the year. As far as the Atlanta, the sale of the Atlanta stores, the gain was about $2 million and you actually see that on the phase of the P&L under other operating income.

John Glass – Morgan Stanley

Thank you.

Nigel Travis

Thanks, John. Next question?

Operator

Thank you. Our next question comes from Jeffrey Bernstein of Barclays. Your line is open.

Jeffrey Bernstein - Barclays

Great. Thank you very much. Good morning. Two questions as well. Just one switching more to the units side, it seems like all the unit growth guidance was intact for the first half at least for the Dunkin U.S. specifically with sub-150, so I just want to confirm that typically accelerates in the second half just wondering if you have the visibility in the back half whether you still think it’s going to be into the same breakout in terms of core, established and what not and whether you think there is potential for an uptick as we now look towards ’15? And then I had one follow-up.

Nigel Travis

Okay. So Jeff good morning, we actually feel good about developments and I touched on that – some of that in my prepared remarks, we felt good about the quarter. We felt good about the first half. Obviously, you are right in my view a bizarre thing, but we are very back loaded. If I could dramatically change one thing about our business that would find some way of changing that because it always comes down to December, but I don’t think that’s ever going to change. It’s just something that it’s always like that. We actually feel very good about the guidance. We feel good about next year. We constantly look at our pipeline. We constantly look at our signings. We feel very good about it. We feel good about the stores in the West. We feel good about stores in places everywhere from California which obviously is the West. Texas as you know in various meetings during the quarter we talked about more details. So we feel good and franchise margins stay at a high level. As I have touched on our biggest issue is when we are awarding new store development agreements franchisees are fighting over them and the biggest challenge that we have is people being told they can’t have it. So I think that’s the high quality problem, so development is not something I worry about.

Jeffrey Bernstein - Barclays

Got it. And then Paul on the leverage side, I think you said you are sitting at 4.5 times now, I am just wondering things like historical pattern would be we should assume another one turn lift in the coming quarters, just wondering without much detail on that, but is that strategy still realistic where rates are today, could you taken on incremental leverage at favorable rates right now or is there some reason why the leverage strategy might change?

Paul Carbone

Yes, so good morning. I would say as we have talked previously from a management perspective our range is 4.5 to 5.5 times levered. By the end of this year we ended the second quarter 4.5. By the end of this we will be down to the 4.2. We continually look to the markets. As far as favorability I can tell you our current term loan hasn’t traded above par. So I think what that’s an indication is the rates we have on that are fantastic, but we continue to look at this. What we want to ensure is any transaction we do is obviously accretive and that we are not tripping the most favored nation clause inside of our current credit agreement, so it’s something that we look at all the time.

Jeffrey Bernstein - Barclays

Great. Thank you.

Nigel Travis

Thanks. Next question.

Operator

Thank you. Our next question comes from Joseph Buckley of Bank of America Merrill Lynch. Your line is open.

Joseph Buckley - Bank of America Merrill Lynch

Thank you. Good morning, I have two questions as well just on the expansion next – I have realized that first half is not the big opening period but you are skewing much more core and established and looks like much less emerging, the west actually looks reasonably in line with your expectations for the full year. But this happened in 2013 as well and I guess I am – my question is do you expect that to balance out, do you expect to reach your full year targets that you gave a few months ago or is something happening that the expansion is going to be a little bit more core and established focus?

Nigel Travis

Joe, this is – good morning. It is a timing issue to your point of West is where we expected it and emerging is a little lower year-to-date and certainly the second quarter, but its timing. We still believe that at the end of the year based on the guidance of 380 to 410 net development, we will be in those ranges that we gave in February.

Joseph Buckley - Bank of America Merrill Lynch

Okay. And then a little bit bigger picture question Nigel you had in short time as a public company several changes on the international management front and now all of a sudden the international business which has always been a bit of footnote is becoming a little bit of an uglier footnote, and so could you talk about how you addressed that near-term without diluting the domestic focus as some of your domestic leaders, I believe have taken on international responsibility. How are you thinking about that, I guess very near term and then maybe a little bit more longer term and how you approach that?

Nigel Travis

Excellent question. And it’s something that I think is a result of the fact that we feel really good about Dunkin U.S. despite our drop of 1% on our comp guidance. We feel that Baskin Robbins U.S. is going in very much the right direction. So, international is getting the focus. So, when I look at international, the first thing you talked about is leadership and we have had various leaderships over my term. I actually could not be happier with the leadership I currently have. And the reason for that is twofold. One is the core of international that we don’t tend to talk about is the area that is run by gentlemen called John Varghese, who is actually based in Dubai, who has been around the business for a long time. He runs the Middle East, Southeast Asia and Australia. That actually is something like half of our international profitability when you look at it and is also comping extremely well.

I feel very good about the work he is doing. He is adding value. He is learning from what we have done in the U.S. and that is correctly. I gave Bill Mitchell, who don’t forget turned around Baskin Robbins U.S., some tough markets. He has got the two joint ventures that we have focused on Korea and Japan, plus he has got China. So, Bill has all the difficult market and he is tackling this extremely aggressively. I mean, I have got Scott Murphy who runs our supply chain in the room here who came back from being with Bill in Korea yesterday. And Bill is really digging into these issues and I feel he is going to have success, because he is a detailed person, but most of all and this is the second point, he understands what we have done in the U.S., he understand what turned the U.S. around and those lessons will help us in international.

You then come on to Europe, which is really a growth area. Paul Twohig is adding tremendous value in Europe. I think already the lessons he has taken into that area have helped us in places like Germany and Spain and some of the newer markets that we got in the horizon like Sweden and Austria. And also I think he is also already adding value in the Latin America market. So, I feel good about the leadership. I don’t think there is going to be a deflection is Dunkin or Baskin U.S., because they have got very strong succession that we have worked on over my five years. And I feel happier now about international leadership. And what I would also say is despite some of the ugly numbers that’s driven by Korea and Japan I think when we get through that you will see posted comp numbers and better profitability coming out in international.

Joseph Buckley - Bank of America Merrill Lynch

Thank you.

Nigel Travis

Thanks Joe. Next question please.

Operator

Thank you. Our next question comes from David Palmer of RBC Capital Markets. Your line is open.

David Palmer - RBC Capital Markets

Hi. Just related to that international front, you didn’t highlight the weak performance in Baskin Robbins JV in Japan. You mentioned Korea, the lower ice cream margins for Basin Robbins International. Could you just provide the color on the sources of weakness within these and what particularly was worse than we would have thought at the beginning of the year? And then how much of a change to your guidance full year is due to these factors and essentially when – in the visibility getting better into ‘15? Thanks.

Paul Carbone

Hey, David, it’s Paul. I am going to start with kind of – I will give you, I will outline the EPS impact and then I am going to turn it over to Nigel to give you broader view of the international business. So, overall, of the EPS reduction about $0.03 was driven by international margin volume and margin rates. So, if you look at that, a couple of things. The first is on the margin rate, we are being – so it’s our one business that is on a margin-based model, so we don’t collect royalties, we actually sell ice cream. We are getting pressure from commodities as our other retailers or other QSR businesses. So, with dairy going up, it’s obviously more expensive to make the ice cream. So, that’s where we are getting the margin pressure a compression.

On the sales side of ice cream, interestingly enough, it’s one of our partners in the Middle East put in a new ERP system and has actually just lowered their inventory level. So, compared to our expectations, has taken a few less shipments of ice cream and that’s kind of the top line ice cream revenue being impacted and then commodities are driving the margin compression resulting in about a $0.03 impact overall to the business. The JVs specifically Japan is giving us another $0.01 of impact as they have lowered, they had a very difficult first half and they have lowered their second half along – that flows through our P&L, their expectations for the second half. And I will turn over to Nigel for a global view.

Nigel Travis

So, just picking up on what Paul said, David, the inventory thing go for them, they are managing their business better. And I can’t contradict that, because no one says more often it’s more important franchisees to build their business and their profitability than me. This happens to what customer like a one-time, so effectively – it’s effectively putting in some ice cream volume back and it was a little bit of a surprise us, to be honest so that’s why there’s difference in guidance, but – they run their business very effectively. They are our partner in Australia, so in many ways, I’m encouraged that they run their business so aggressively and I want to reiterate, we had great comps in the Middle East with Baskin Robbins. So, it’s just down for this one-time delay.

On Japan, very concerned about Japan, Bill mentioned he’s attacking it very aggressively. He’s there today. We’re disappointed with some things that they did. We don’t think they actually turned on a time we take some of the other elements of their business fast enough. They’ve had that message. I think you will see, it’s going to take a little bit of time to turn around. But I think we will get a message over to those and I think we will get our business going back again. What I would say is despite the negative comps, we still have very high volume on a per store basis. We still think Japan is a great market for ice cream, but again we’re disciplined to have it in Q2 and we’re doing everything to get it done in the right direction.

David Palmer - RBC Capital Markets

Thanks.

Paul Carbone

Thanks, David. Before we go the next question, I just wanted to clarify something that we said during our prepared remarks, the thing that Nigel may have mentioned getting to $2.5 million Perks members by the end of the quarter and although on many meetings when he pushes John Costello, very, very hard, I just want to reiterate that but $2.5 million was our goal by the end of the year.

David Palmer - RBC Capital Markets

Thank you.

Nigel Travis

So with that, next question please.

Operator

Thank you. Our next question comes from Will Slabaugh of Stephens. Your line is open.

Will Slabaugh - Stephens

Wanted if you could talk a little bit more about how the newer products have been mixing and primarily on the PM food side with a grilled chicken, Angus Steak etcetera. And as a quick follow-up to that, I know you’ve been aggressively with your new product development includes the smart menu etcetera. But just from a high level, do you have any concern that some of your offerings have been off trend with the movement towards health and wellness etcetera and may be that, may be having a modestly negative impact on the business?

John Costello

Yes, it’s John again. So the answer is no, not at all, we’ve – we’re really implementing what we call it choice strategy and what some people call a barbell strategy which is offering both indulgent products and DD Smart products. So, and what we’re seeing here is growth in both of those products. So for example, two of our most successful product are the big and toasted, which is the big, hearty, fill you up breakfast sandwich and our Turkey sausage breakfast sandwich, which is a DD Smart lower calorie offering. So, we continue on the strategy to offer really choice to big fill you up products like big and toasted to DD Smart products like Turkey sausage. We also give people a choice in carriers, so again you can have products on bagel for a breakfast sandwich, but you can also get them on our wakeup wraps, which again offer smaller portions and lower. So, interestingly enough, we continue to see growth in both sides.

Another example is iced coffee, where we have a very strong rapidly growing business. Our regular plain iced coffee, if you will, has no calories growing very rapidly. But we also offered BR flavored iced coffees which are a little bit more indulgent and are also very successful. So we really are offering a choice strategy and what we are seeing is growth in both sides of that and we tend to balance that. We also expand – rolled out in Q2 our Apple Chicken Sausage. And here again for people who want an alternative to pork sausage, the Apple Chicken Sausage was very well received. So our strategy is to offer choice on both DD smart and indulgent and I think it’s telling that our top two selling strategies, our breakfast sandwiches are big and toasted on one side and the turkey sausage on the other. And you will continue to see growth in both big hardy products as well as growth in DD smart products.

Will Slabaugh - Stephens

And as far as the PM offerings, I assume you are pretty pleased with those as well?

Paul Carbone

Yes, sorry. The PM offerings are going very, very well. We continue to see very robust growth in our PM sandwich line. And so what we are seeing is two things, we are seeing overall growth in beverages. So our iced coffee and iced tea business continues to grow very, very nicely. Now iced coffee is an all day business. But yes, our PM sandwich platform continues to go very well. We rolled out a multi-grain flatbread carrier and that’s been very well received. And then that also falls into the DD smart for people who want less bread on their sandwiches. So we continue to be very pleased with the growth on our PM platform. And we think that both chickens and Angus will sustain that growth.

Nigel Travis

And I think just to pull that together. As I said in my remarks we had record numbers coming to our stores in the afternoon.

Will Slabaugh - Stephens

Great, thanks guys.

Nigel Travis

Thanks. Next question, operator.

Operator

Thank you. Our next question comes from Jeff Farmer of Wells Fargo. Your line is open.

Jeff Farmer - Wells Fargo

Great. Thanks. In reference to the challenging economic environment and the heightened competitive intensity for the Dunkin U.S. business, just thing about that is there any reason to believe that the economic or competitive headwinds will moderate in 2015, when you guys look out there expect life to get a little bit more challenging or is this probably about as bad as it’s going to get in the first half of ‘14?

Nigel Travis

Jeff, I think that’s an interesting question I think about that a lot myself and we meet with all kinds of people and the last thing I am is an economics predicted. I think if I look at all the same data as you have been saying and this is not looking at out business. You think that the job seem to be getting a bit better. You think that things are improving so that should be helpful. However, it seems as I mentioned earlier, the lower end consumer is really struggling and doesn’t seem to seeing any improvement. So that’s concerning. So I think it’s going to be a little bit of the same. There might be a bit of pick up. I actually have said fairly strongly. I think this was actually said by the IMF as well that we probably need some kind of fiscal stimulus on top of all the work by the Fed. Whether that’s immigration reform, whether that’s doing something about unemployment benefit but to be honest I can’t see any of that happening. So I think without that you are going to see much of the same, I think that’s my outlook for rest of the year.

Jeff Farmer - Wells Fargo

Alright, thank you.

Nigel Travis

Thanks, Jeff. Next question, please.

Operator

Thank you. Our next question comes from Andy Barish of Jefferies. Your line is open.

Andy Barish - Jefferies

Hi, guys. On the back half I am just trying to balance and make sure I am thinking about this correctly, it sounds like with the protein focus versus some of the things last year I don’t have the whole marketing calendar in front of me, maybe you are trying to drive a little bit more check and mix to offset some of the discounting, am I thinking about that correctly and is there some incremental pricing that you guys are talking about with the franchisees potentially for the back half to get more than that 50 basis points or so?

Nigel Travis

Okay. So, firstly I will reiterate again. We were very pleased with our transaction growth. Our programs are very focused on driving transactions, because that’s if you like the heartbeat of any retail organization. So, on pricing, here is what I would say. In the first half, we saw just under 50 basis points of pricing. We gave guidance at the start of the year of about 100 basis points. We think we will end the year probably just less than 100 basis points, but directionally in the same area. We will probably get there in a slightly different way, because what has happened is because of the competitive set that we have discussed we have obviously seen that we have had to do more discounting than we expected at the start of the year. Now, that is offset by us talking to our franchises, suggesting to them, because remember they are the ones they have to make a decision. It is not us because that’s the law. We have great analytical tools. We have shown us the franchisees. We make recommendations and the recommendations offered us to increase prices and we do it in a selective basis, the franchisees then either accept or reject those recommendations. I think you will see more price income proof. And at the end of the year, it will be something towards 100 basis points and you will see that both on beverages and food.

John Costello

John, also while we – it was John. While I answered the question on some of the products, our innovation just isn’t on protein. Through the end of the year, you will see product innovation on both the beverage and food side across the line for the second half.

Andy Barish - Jefferies

Thank you.

Nigel Travis

Thanks, Andy. Next question please.

Operator

Thank you. Our next question comes from David Tarantino of Robert W. Baird. Your line is open.

David Tarantino - Robert W. Baird

Hi, good morning. First of all, a clarification question on the second half implied comps guidance, Paul, I think you mentioned that you exited Q2 on a high note and I was just wondering if may be, you could comment on whether that the recent trend or sort of the trend exiting the quarter inside the range that you need to deliver the second half guidance?

Paul Carbone

Yes, David, I think great question. And as we say we never comment on monthly comp so, I applied you for asking it in a different way. What I will tell you is exiting like I said, the second quarter as we went through, it accelerated obviously at the end of the quarter of 1.8 and we feel comfortable with the rate that we exited the quarter at June to reach that two to three range. I know I’m not answering your question directly, but we don’t comment on actual monthly comps. But we do feel as we exited the second quarter comfortable in that two to three range.

David Tarantino - Robert W. Baird

Great, fair enough. And then my second question really is related to the development in west and emerging markets and I’ve heard a fair amount of skepticism from some investors on your outlook for development in those markets and I was just wondering if you could comment on what you’re seeing from a demand perspective and what some of the puts and takes and ramping up some of the openings in those markets might be.

Paul Carbone

Okay. So, what I am going to do, David, is I am going to answer your question. I am going to ask John Costello who recently spend some time out west with some of our newer franchisees in California, because he came back more enthusiastic about that and just about anything I’d say recently so, the demand I think I’ve covered couple of times, the demand for our stores is huge, I mean, holding franchisees back is one of the things we tackled. It is significant. We have people fighting over territory. So, there is no issue with demand and territories that we’re excited about range right across the west, Texas, we’re seeing terrific results. We’re seeing great demand and with California, we had several people for every slot in California and we choose on quality and record and operational skills, all that kind of stuff that we’ve explained anytime before so, no issues on demand. The quality of the franchisees I think goes up exponentially, which I think is very important, because you want the very best franchisees either existing or new. And John, do you still want to quickly summarize your feelings after the meeting?

John Costello

Yes, I would agree. We have had obviously very strong demand so for it, but having spent time out there, I came back even more optimistic for several reasons. One is I think we have very strong franchisee partners out there. They are very good operators. They have very well-developed real estate and development skills and are working closely with our team. They have a very strong commitment to build the business. So, I think we have – we are going in with very strong franchisees with broad-based skills. The second part that makes me optimistic is that there is very strong consumer demand for the brand. We have done research out in California. And as you recall, we have been selling our bag coffee in California for a number of years and it’s one of our strongest bag coffee markets in the country. We also have been running national advertising for the past few years. So, we think there is strong consumer awareness and demand for the brand and we have very strong partners who have all of the key skills. So, I came back very optimistic about our prospects in California.

Nigel Travis

Thanks, David.

David Tarantino - Robert W. Baird

Thank you.

Nigel Travis

We are coming to the top of the hour. Let’s take two more questions please.

Operator

Thank you. Our next question is from Howard Penney of Hedgeye Risk Management. Your line is open. Howard, you might want to check your mute button. Okay. We are going to move on to Matt DiFrisco of Buckingham Research. Your line is open.

Matt DiFrisco - Buckingham Research

Thank you. Just a couple of quick clarifications and I had a question, did your guidance include further share repurchase or would incremental share repurchase in the back half of the year be incremental to guidance?

John Costello

It would be incremental to guidance.

Matt DiFrisco - Buckingham Research

Okay. And then your lowered guidance for the JV, that is purely Korea or what else was factoring into that?

John Costello

It’s a combination of – it’s mainly actually Baskin Japan, but there is softness in Korea Dunkin as well, but the majority of that is Baskin Japan.

Nigel Travis

I think it was same just the total clarification in case anybody is new to the business, we had in Korea two JVs, Baskin Robbins, which is performing extremely well and Dunkin Korea, which is performing less well and then there is Baskin Korea and Baskin in Japan.

Matt DiFrisco - Buckingham Research

Got it, okay. And then my question on development, I guess I have heard a couple of times in the call, demand is very strong domestically for Dunkin and the brand, I hear that, I see the unit economics, but I guess I wonder as far as the development or the net gross development, it does look like for lack of a better term, it looks like it might be also another similar to the comp that it’s a little more optimistic picking up as far as growing on a year-over-year basis. Otherwise, it looks like if you were to do the same amount of openings, you would probably be on the low end of 380 to 410. If demand is – is there something with the weather effect or going on or credit markets that’s maybe not fulfilling why are we turning away so many when it seems like we are not really on the upper end of the pace of growth to hit that full target. Volumes are they – how are the volumes, are they okay or are they bigger than last year, I was just curious on sort of the dynamic why demand isn’t being transcended into overall development net store openings?

Nigel Travis

Okay. So, well firstly, development we give guidance for the year. We feel very strongly what we have – very strongly in support of our guidance for the year. We feel good about it. When I talk about demand, if we setup a store development agreement, we have a number of people who go for it and then we choose someone to do it. Well, that means we have to reject it. That’s what I mean by that. I think it is being translated. I think you are taking, if you like the numbers, trying to work it out on the quarterly basis, that doesn’t necessarily work, that’s why we give annual guidance. We feel good about the numbers. And I think Paul is going to add something in a minute. We feel good about as John said the quality of the franchisees. So, development, I know a lot of people have been writing notes from time-to-time have got me as you say because they come out with all kinds of stuff that’s not true. We feel very good about development. It will continue to increase year-by-year. I am not sure how to say any clearer. The economics we went through in the last quarterly call and Paul is there anything you want to add?

Paul Carbone

Yes. So, Matt, I think on your direct question on the numbers. So year-to-date, we are at a 144 net development in Dunkin. Last year at this time, we are at 141. So, they were up three year-over-year and obviously that full year guidance is higher than that at the range. So, two things there. Last year, we talked about how or we continue to talk about how we tried to move stores earlier in the year. Last year, we had a very strong first half and to the degree it’s not the same on a percentage basis this year. Now, the second thing is if you look at this year of 144 net and you picked the middle of our range of 380 to 410, call it 395, on a percent basis other than last year, if you go back two years, three years, four years, we are opening up a bigger percent in the first half of the year than we have in any of those other than last year. So, a good question from a pace we are on pace internationally to where we want to be and I think Nigel discussed the kind of the unit economics in that piece of the development.

Matt DiFrisco - Buckingham Research

That’s right.

Nigel Travis

One question please.

Operator

Thank you. Our last question comes from Michael Gallo of CL King. Your line is open.

Michael Gallo - CL King

Hi, good morning. Just one clarification, Paul, the Baskin Robbins International profitability being weaker, how much of that impact was the one-time adjustment for the ordering from your Middle Eastern franchisees? Thank you.

Paul Carbone

Yes, thanks Michael. What we said is overall the step down in guidance was $0.03. It was a couple of cents if you break that down more the couple of cents due to the margin compression and about a penny due to the top-line ice cream sales.

Michael Gallo - CL King

Okay, great. And then on the margin compression is there any differences there on timing or pricing obviously you’ve gotten hit with some higher dairy cost, should we expect that to normalize out overtime or how you addressed that?

Paul Carbone

Yes, so, from a pure margin rate, it will get a little bit better compared to the year-to-date numbers. The year-to-date number is slightly under 30%. It will get very – we’re talking 10, 20 basis points better for the full year, the back half of the year. We did take some pricing in May that we’ll get the benefit for the back half of the year, but generally where you see as year-to-date is where we’re going to end up for the full year.

Michael Gallo - CL King

Thank you.

Nigel Travis

Thank you very much and thank you everyone for your questions and before we finish up completely, I wanted to say that I look forward to seeing many of you at our 2014 Investor and Analyst Day which is going to be in Dallas, Texas on September 17. So, there is no question, this is tough quarter and as we leave this call as you know that we’re very focused on driving stronger comp growth across the whole business. So particularly in Dunkin’ USA, Dunkin’ Korea and Baskin’ Japan, they’re the areas that we’re very focused on, but standing back are remained extremely confident that the business will quickly return to the type of growth we all expect. So, thank you everyone for calling in today and have a good day.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes today’s program. You may all disconnect. Everyone have a great day.

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Source: Dunkin' Brands' (DNKN) CEO Nigel Travis on Q2 2014 Results - Earnings Call Transcript

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